Friday, August 28, 2009

The vicious cycle of too big to fail

Remember how we got into the financial mess? Big banks assumed that if their investments turned sour they'd be bailed out. The assumption was justified because if they were punished (not bailed out) the systemic risk they had created will pull down the financial system.

The Washington Post:

Fresh data from the FDIC show that big banks have the ability to borrow more cheaply than their peers because creditors assume these large companies are not at risk of failing. That imbalance could eventually squeeze out smaller competitors. Already, consumers are seeing fewer choices and higher prices for financial services, some senior government officials warn....Large banks with more than $100 billion in assets are borrowing at interest rates 0.34 percentage points lower than the rest of the industry. Back in 2007, that advantage was only 0.08 percentage points, according to the FDIC. Such differences can cause huge variance in borrowing costs given the massive amount of money that flows through banks.

How to break this vicious cycle? It is hard to see how the government could credibly commit not to bail out big banks. But if bigness itself creates a systemic risk -- a risk that cannot be remedied by shutting down a sick bank because the infection will only spread more virulently throughout the system -- the solution would appear to a tax on being big. It's an externality.

2 Comments:

But surely if we place some form of limited liability on the bank directors, they would behave in a more responsible manner? We don't have to threaten them with death, or even prison, but the potential loss of all their assets would make them think twice about taking on risky debt, surely?